APPENDIX

N o t e s f o r FOMC M e e t i n g December 1 7 , 1 9 9 1 M a r g a r e t L . Greene S i n c e your l a s t meeting, t h e d o l l a r has been caught i n a t u g of war between two o p p o s i n g f o r c e s . The d e e p e n i n g gloom o v e r

p r o s p e c t s f o r economic r e c o v e r y , a s w e l l a s c o n c e r n a b o u t t h e e n s u i n g p o l i t i c a l p r e s s u r e , e x e r t e d downward p r e s s u r e a g a i n s t t h e d o l l a r throughout t h e p e r i o d . A t t h e same t i m e , a n x i e t i e s a b o u t t h e

d i s i n t e g r a t i o n o f t h e USSR gave r i s e t o spasms o f demand f o r d o l l a r s t h a t sometimes pushed t h e c u r r e n c y up and o t h e r w i s e k e p t a l i v e t h e r i s k of l o s s f o r t h o s e tempted t o a g g r e s s i v e l y s e l l ?he d o l l a r s h o r t . O v e r a l l , t h e n e g a t i v e f o r c e proved t o be t h e more d o m i n a n t . But t h e e x t e n t t h a t t h e d o l l a r d e c l i n e d a g a i n s t i n d i v i d u a l c u r r e n c i e s depended on d e v e l o p m e n t s a b r o a d . only 1 - 1 / 2 p e r c e n t . A g a i n s t t h e y e n , t h e d e c l i n e was

The J a p a n e s e c u r r e n c y i t s e l f was undermined by

c o n c e r n a b o u t a s l o w i n g e x p a n s i o n , problems w i t h J a p a n ’ s f i n a n c i a l m a r k e t s and b a n k i n g s t r u c t u r e , and t h e l i k e l i h o o d o f f u r t h e r i n t e r e s t rate cuts there. The d e c l i n e o f t h e d o l l a r a g a i n s t t h e German mark

was. by c o n t r a s t . more t h a n 4 - 1 / 4 p e r c e n t . I n f a c t . t h e s t r e n g t h e n i n g o f t h e German mark o v e r a l l , amid a reawakening of t h e p e r c e p t i o n o f exchange r a t e r i s k , i s p r o b a b l y t h e

m o s t i m p o r t a n t development o f t h e exchange m a r k e t s d u r i n g t h e
intermeeting period. The h e i g h t e n e d a w a r e n e s s o f exchange r a t e r i s k was p r e c i p i t a t e d by d e v e l o p m e n t s i n a r a t h e r remote p l a c e . F i n l a n d . For

a b o u t a month t o mid-November, t h e F i n n i s h a u t h o r i t i e s had been t r y i n g
t o r e s i s t p r e s s u r e s a g a i n s t t h e i r c u r r e n c y t h a t r e f l e c t e d , among o t h e r

t h i n g s . s e v e r e r e c e s s i o n , t h e l o s s of i t s m a j o r e x p o r t m a r k e t s i n t h e USSR and E a s t e r n E u r o p e and f r a c t i o u s wage n e g o t i a t i o n s . The

a u t h o r i t i e s had i n t e r v e n e d a n d , a s t h e i r f o r e i g n c u r r e n c y s a l e s

-2

approached out of r e s e r v e s .

e q u i v a l e n t , t a l k s p r e a d t h a t t h e c o u n t r y had r u n On November 1 4 , t h e c u r r e n c y succumbed t o m a r k e t

p r e s s u r e s and t h e n e x t d a y . t h e F i n n i s h a u t h o r i t i e s s e t a new peg f o r t h e markka a g a i n s t t h e ECU. e f f e c t i v e l y d e v a l u i n g t h e F i n n i s h c u r r e n c y by 1 2 . 3 p e r c e n t . The m a r k e t was awed by t h e s i z e of t h e p r e s s u r e s t h a t f l a r e d up a r o u n d s u c h a t h i n l y t r a d e d c u r r e n c y . The m a g n i t u d e o f t h e f l o w s

d e m o n s t r a t e d t h e e x t e n t i n v e s t o r s around t h e world had been d i v e r s i f y i n g i n t h e p a s t s e v e r a l y e a r s i n o r d e r t o e n h a n c e y i e l d when i n t e r e s t r a t e s i n t r a d i t i o n a l m a r k e t s had d e c l i n e d . The e p i s o d e a l s o

brought i n t o question t h e a b i l i t y of a u t h o r i t i e s t o resist market pressures.
A f t e r b e i n g s u r p r i s e d by t h e d r o p i n t h e F i n n i s h m a r k k a ,

i n t e r n a t i o n a l i n v e s t o r s sought t o s h i f t t h e currency composition of t h e i r p o r t f o l i o s t o w a r d t h e German mark. The 8 - 1 / 4 p e r c e n t y i e l d

a v a i l a b l e on 1 0 - y e a r German government s e c u r i t i e s , f o r e x a m p l e , came t o look l i k e a reasonable r e t u r n . I n v e s t o r s were w i l l i n g t o f o r e g o

t h e a d d i t i o n a l 3 t o 4 p e r c e n t a g e p o i n t s b e i n g o f f e r e d i n some o f t h e o t h e r , s o - c a l l e d " h i g h - y i e l d i n g ' ' c u r r e n c i e s of E u r o p e , which s u d d e n l y was p e r c e i v e d a s s c a n t c o m p e n s a t i o n f o r a n o v e r n i g h t d e v a l u a t i o n . The

a p p r o a c h o f t h e European Summit a t M a a s t r i c h t o n l y added t o t h e s e n s e of uncertainty. A l t h o u g h m a r k e t p a r t i c i p a n t s were r e a s o n a b l y s u r e

t h a t none of t h e EMS c o u n t r i e s would be g o i n g i n t o t h e d i s c u s s i o n o f European Monetary Union s e e i n g a change i n p a r i t y f o r t h e i r c u r r e n c y , t h e p o s s i b i l i t y e x i s t e d t h a t , e i t h e r f o r p o l i t i c a l reasons o r i n r e s p o n s e t o m a r k e t p r e s s u r e s , an EMS r e a l i g n m e n t might o c c u r . The i m p a c t o f t h e s e u n c e r t a i n t i e s on EMS c u r r e n c i e s was uneven. P r e s s u r e s w i t h i n t h e EMS f o c u s e d on t h o s e c u r r e n c i e s t h o u g h t

t o b e m o s t e x p o s e d , s u c h a s s t e r l i n g . t h e I t a l i a n l i r a and t h e F r e n c h

-3

franc.

Intervention in support of these currencies came to nearly $9

billion equivalent.
But outside the EMS. the Swedish krona--acurrency, like the
Finnish markka. recently pegged to the ECU unilaterally--got caught up
in a maelstrom of selling pressures. December. the Swedish Riksbank sold During November and early
equivalent of foreign
The Riksbank

currencies, mostly German marks to support its currency.

raised interest rates 1 percent on November 26 to show the market the
government’s determination to maintain the currency’s exchange rate.
But rumors of devaluation spread and. within a week. the Riksbank had
to hike its official lending rate again--thistime by another 6
percentage points to 17.5 percent-to stabilize market conditions.

In the past week o r s o , the pressures among the European currencies appear to have subsided somewhat. Sweden’s strong monetary move has succeeded in attracting reflows. The Riksbank has bought back nearly all of the foreign currency it had previously sold and has scaled back its official lending rate 2-1/2 percentage points to 14 percent. The Maastricht Summit is over. there was no realignment, and

-4

t h e German mark i s s e e n a s h a v i n g l i t t l e t o g a i n from t h e a g r e e m e n t s on European Monetary and P o l i t i c a l Union. But t h e h e i g h t e n e d s e n s e of exchange r a t e r i s k i s n o t completely d i s p e l l e d . P a r t l y a s a r e s u l t , t h e t r e n d t o lower i n t e r e s t

r a t e s i n t h e European c o u n t r i e s o t h e r t h a n Germany i s seen a s h a v i n g been s t a l l e d i f n o t r e v e r s e d . Many o f t h e s e c o u n t r i e s had been

a t t e m p t i n g t o e a r n t h e r e s p e c t of t h e m a r k e t p l a c e - - n o t o n l y by b r i n g i n g down t h e i r d o m e s t i c i n f l a t i o n b u t a l s o by t y i n g t h e i r c u r r e n c y i n some way t o t h e m a r k - - s o a s t o s q u e e z e t h e e x c h a n g e r a t e r i s k o u t of n o m i n a l d o m e s t i c i n t e r e s t r a t e s .
F o r much o f t h e y e a r

b e f o r e t h e s e e v e n t s , European i n t e r e s t r a t e s i n t h e s e c o u n t r i e s had been moving l o w e r , o f f s e t t i n g t o same e x t e n t t h e upward move o f German rates. Now, EMS c e n t r a l b a n k s a r e p e r c e i v e d a s h a v i n g t o b e a l e r t t o

t h e need t o u s e s h o r t - t e r m i n t e r e s t r a t e s t o d e f l e c t e x c h a n g e r a t e p r e s s u r e s s u g g e s t i n g t h a t t h e scope f o r f u r t h e r convergence o f i n t e r e s t r a t e s may be l i m i t e d . A t t h e same t i m e , t h e m o n e t a r y

a u t h o r i t i e s i n Germany’s n e i g h b o r i n g c o u n t r i e s a r e growing c o n c e r n e d t h a t t h e i r e f f o r t s t o maintain anti-inflationary discipline i n t h e i r own c o u n t r i e s may be undermined by t h e c o s t - p u s h p r e s s u r e s s o e v i d e n t t o d a y i n Germany. They. t h e r e f o r e , a r e no l o n g e r p u t t i n g p r e s s u r e on On

t h e Bundesbank t o r e f r a i n from t i g h t e n i n g m o n e t a r y p o l i c y f u r t h e r . b o t h c o u n t s t h e s e c e n t r a l b a n k s seem r e c o n c i l e d t o t h e p r o s p e c t o f k e e p i n g t h e i r own i n t e r e s t r a t e s f i r m , e v e n i n t h e f a c e of s l o w i n g growth. O u t s i d e t h e EMS. t h o s e c u r r e n c i e s t h a t had p r e v i o u s l y

b e n e f i t t e d f r o m h i g h y i e l d s and l a r g e - s c a l e c a p i t a l i n f l o w s h a v e a l s o weakened c o n s i d e r a b l y d u r i n g t h e i n t e r m e e t i n g p e r i o d . Two o f t h e s e

c u r r e n c i e s , t h e Canadian d o l l a r and t h e A u s t r a l i a n d o l l a r , h a v e b e e n

-5

hit by reportedly heavy liquidation of investments by Japanese
investors.
Looking forward, it is hard to know how much of the speculative juices unleashed in November will stay active or how much the lessons of the episode will affect investor behavior. Once

trading resumes in the new year, the perception of increased foreign exchange risk could impel fund managers to seek higher returns or react more swiftly to any signs of exchange market disturbance. Thus, at a time when we are being reminded to "Remember Pearl Harbor." the international fund managers may be responding to the refrain. "Remember the Finnish Markka. " In closing this part of my report on foreign exchange market
developments, Mr. Chairman, I request approval of the sale of $200
million equivalent marks to the Swedish Riksbank.

I would also like to report to you on our discussions with
the Bundesbank regarding the possibility of altering the doubleforward investment facility provided for the investment of the bulk of the U.S. authorities' Deutsche mark reserves. Mr. Cross explained to you earlier this fall how the current arrangement exposes the Bundesbank to losses as a result of a maturity mismatch on its balance sheet.

I believe he informed you that we are working with the

Bundeibank to establish a new pricing arrangement for the facility which would reflect the Bundesbank's need to minimize its exposure to losses and still meet U . S . authorities' desire t o receive a marketrelated rate of return. It had been our understanding that the Bundesbank wanted to have the issue settled by year-end. We. therefore, hoped to be able to reach agreement on a new pricing mechanism by now, s o that you could have considered it at the same time as the annual renewal of the

-6

swap l i n e w i t h t h e Bundesbank.

W have p r e s e n t e d s e v e r a l a l t e r n a t i v e e

p r o p o s a l s t o t h e Bundesbank s i n c e e a r l y f a l l , b u t t h e y have n o t b e e n a s q u i c k a s we had e x p e c t e d i n r e s p o n d i n g . p r o j e c t i s underway. To d a t e , w e h a v e r e c e i v e d c o n f i r m a t i o n o f r e n e w a l on a l l of t h e S y s t e m ’ s r e c i p r o c a l swap a r r a n g e m e n t w i t h t h e e x c e p t i o n o f t h o s e
o f t h e c e n t r a l banks o f Germany, I t a l y and t h e N e t h e r l a n d s .

I n a n y c a s e , work on t h i s

W expect e

a l l t h r e e w i l l be renewed by t h e i r December 2 8 m a t u r i t y d a t e s . A d d i t i o n a l l y . t h e T r e a s u r y a n t i c i p a t e s t h a t i t s swap a r r a n g e m e n t s w i t h Germany and Mexico w i l l be renewed by t h e i r J a n u a r y m a t u r i t i e s . I n one o f t h e S y s t e m ’ s swap a r r a n g e m e n t s t h a t s t i l l h a s n o t been renewed
--

t h a t w i t h t h e N e t h e r l a n d s bank - - a change i n t h e The Dutch c e n t r a l bank

i n t e r e s t r a t e p r o v i s i o n would be d e s i r a b l e .

h a s a s k e d t h a t we make one m o d i f i c a t i o n t o u s e t h e Dutch i n t e r b a n k o f f e r e d r a t e , i n p l a c e of a n o b s o l e t e N e t h e r l a n d s T r e a s u r y p a p e r r a t e , i n d e t e r m i n i n g t h e f o r w a r d r a t e on swap d r a w i n g s i n i t i a t e d by t h e Federal Reserve.
Mr. Chairman, I r e q u e s t a p p r o v a l f o r t h a t amendment.

N o t e s f o r FOMC Meeting P e t e r u. s t e r n l i g h t Deceiiiber 1 7 , 1 9 9 1 D o m e s t i c Desk o p e r a t i o n s s i n c e t h e l a s t m e e t i n g of t h e
C u i i i m i t t e c , on tloveiiiber 5 , e f f e c t e d two s m a l l e a s i n g s t e p s i n

policy.

Tlie f i r s t was t a k e n

011

November G , c a r r y i n g o u t t h e
It entailed

Culll1nittee's d e c i s i o n a t the p r e v i o u s d a y ' s m e e t i n g .

a r e d u c t i o n i n the e x p e c t e d F e d e r a l f u n d s r a t e from 5 t o
LI

3/r1

p e r c e n t , a n d was implcmetited i n c o n j u n c t i o n w i t h a
f,

I/% p e r e e l i t a y e p o i n t r e d u c t i o n i n the d i s c o u n t r a t e , from
4 l/2

to

percent.

The e x t e n t of the move was conveyed t o t h e market

by a r r a n g i n g c u s t o m e r - r e l a t e d r e p o s t h a t morning a t a time when
the p r e v a i l i n g funds r a t e had a l r e a d y moved tu 4 3 / 4
ill

percent

clle im1wdiate wake of t h e

announced d i s c o u n t rate cut.

The s e c o n d e a s i n g s t e p was t a k e n a month l a t e r , on
Deceliiber 6 ,

the d a y of a p a r t i c u l a r l y weak employment r e p o r t .

'I'lie move was made a g a i n s t t h e background o f t h a t r e p o r t , o t h e r

e v i d e n c e of s l a c k econoaiic a c t i v i t y , a sense of a b a t i n g i n f l a t i o n
and s L i l 1 - s l o w a<jcjreyaLes.

( t h o u g h improving) growth i n b r o a d money

The e x p e c t e d F e d e r a l f u n d s r a t e w a s r e d u c e d by a

r u ~ - t l l e r1/4 p e r c e n t to 4 1/2 p e r c e n t .

T h i s move, t o o , was

r e a d i l y conveyed t o the market by e x e c u t i n g c u s t o m e r - r e l a t e d
1-epos, a s t h e p r e v a i l i n g Fed. f u n d s rate t h a t morning had slipped

t o 4 1/2 percent i n w i d e s p r e a d a n t i c i p a t i o n of t h e SlJstclIi's lilovc.
Illdeed, tiad t h e r e not h e n a d e c i s i o n t o t a k e a11 c a s i n g s t e p ,
1.1~

-2-

would have had to drain reserves that day--despite the projected
add-need for the period--in order not to mislead market
participants.
The first easing move was accompanied by no net change in the path borrowing allowance, as a
$25

million increase

associated with the re-emergence of a positive spread between the expected funds rate and the discount rate was offset by an equal downward technical adjustment to allow for ongoing declines in seasonal borrowing.
$25

The second policy move was accompanied by a

million cut in the borrowing allowance and there were three
$25

other downward technical adjustments of

million each to For the whole

parallel the receding level of seasonal borrowing.

period, the path borrowing allowance was reduced by $100 million to $75 million. Over most of the period, borrowing ran a little below the path allowance as adjustment borrowing remained particularly light except for a bulge at the end of the December 11 reserve period. Funds rates hewed fairly closely to the expected level,

averaging a shade to the higher side, but with soft rates on a number of days tending to inhibit the Desk's ability to meet projected reserve needs lest the market misconstrue the Desk's action as still further easing steps. This was notably the case on the December 11 settlement date when a large reserve need was foreseen but the funds rate only grudgingly crept up to the desired
4 1/2

percent level by late morning.

With the market

seemingly thirsty for evidence of further ease, the Desk felt

- 3constrained to do no more than a moderate reserve provision, recognizing that a sharp tightening might well occur late in the day.
As

it turned out, funds softened for a time that afternoon,

touching a low of 4 percent, but then tightened and climbed as high as 15 percent, while borrowing jumped to about $600 million on the day. Typical late-year reserve needs dominated the period, related to currency outflows and increased required reserves, punctuated further at times by some unexpectedly high Treasury balances. The bulk of the need was met with outright purchases,

including nearly $5 billion of bills and notes purchased from foreign accounts and $2.3 billion of coupon issues bought in the market--the System's first market purchase of coupon issues since April 1989. While the total outright purchase of
$7.2

billion

were thus substantial, it did not prove necessary to use the enlarged leeway provided by the Committee. Outright purchases were supplemented on most days
either by multi-day System repurchase agreements, or customer-
related repos. There were no matched sale-purchase transactions

in the market, and just one modest redemption of an agency issue.
Looking ahead, repurchase agreements likely will be
used heavily to meet seasonal needs through year-end, while
outright purchases are probably about over for the year, as we
enter soon after year-end into a period of substantial seasonal
reserve absorption.
It may be noted, though, that net outright purchases so

-4-

far this year add up to a record $31.4 billion, including

$20.2 billion of bills and $11.3 billion of coupon-bearing

issues--the latter mainly bought from foreign accounts.

The

exceptionally large outright purchases reflected needs stemming
chiefly from large increases in currency in circulation, and the
need to replace reserves absorbed by the declines in foreign
currency holdings.
Yields declined across a broad front during the recent
intermeeting period--with the larger declines weighted as usual
toward shorter maturities, so that an already steep yield curve
steepened further. The declines stemmed from increasing market

perceptions that the economy's pick-up beginning toward mid-year,
while never very strong, recently has lost what little momentum
it had. Most market participants see the current quarter and the

next quarter or two as essentially flat while a resumption of
significant growth is not expected before about the middle of
next year.
Each easing step by the Fed has been widely anticipated and promptly followed by expectations of further steps to come, though some observers are expressing the views that we could, or should, now be nearing the end of the line for easing moves.
A

widely held current consensus would look for a

further 1/2 point discount rate cut and a reduction in the funds rate by at least 1/4 point between now and year-end. Market

observers seem to have been particularly impressed by the weakness in various confidence measures and the sour mood in the

-5-

business community as many lay-offs are announced.

Inflation

news is recognized as mixed, but most commentators express
confidence that core rates are slowly abating.
Responding to actual easing moves and anticipations of moves, Treasury bill rates came down by about 50 to 65 basis points in the recent period. saw average rates of and
4.80 4.14

Yesterday's 3- and 6-month auctions
4.19

and

percent, compared with

4.74

percent just before the early November meeting.
$ 2 1/2

The

Treasury raised about over the interval.

billion, net, in the bill sector

Private short-term rates also fell, including

the bank's prime rate which was reduced 1 / 2 point shortly after

the early November discount rate cut. Shorter-term Treasury coupon issues were also down sharply in yield--with declines of about 60 to 65 basis points out to three years.
25-45

The five to ten-year yields were down abou

basis points as buyers reached out in maturity to capture The long end came off by a more

dwindling rates of return.

modest 10 to 15 basis points--a somewhat grudging move that reflected concerns that budgetary discipline might be weakened in the effort to provide greater fiscal stimulus to the economy. Continuing reports of Japanese Selling of long Treasury zeros and whole bonds were also a factor holding up longer rates. Some

observers also sensed concern that confidence in declining
inflation was not as robust as might be needed to produce more
meaningful rate declines. Meantime, the long Treasury market got

some periodic bursts of support when Secretary Brady commented to

-6-

Congressional committees that the Treasury was looking at the
possibility of reducing its reliance on long bonds in financing
the deficit.
In all, the Treasury raised about $32 billion in the
coupon market. The bulk of this, nearly $19 billion, was raised

in the November refunding auctions, which were just getting under
way the day of the last Committee meeting. In those refunding

auctions the bidding interest was rather weak for the 3-year
issue, and not much better for the 10-year, but then quite strong
for the 30-year apparently because rates had temporarily backed
up to the appealing 8 percent level.
All three of the new issues
later moved to sizable premiums over their auction prices in the
market's subsequent downward rate moves.
Rate declines in the Treasury market were roughly
paralleled in the corporate market, encouraging a heavy volume of
new issuance including a moderate volume of below investment
grade securities.
Issuance of tax exempts was also heavy
although their rates showed little change over the period.
New
issue activity can be expected to taper off in these markets
through year-end. Much of the new issuance, to be sure, is

related to debt restructuring rather than net new borrowing.

A

final note:

as of this point, there seems to be

little evidence of generalized year-end pressure facing the
financial markets--a welcome contrast with last year when such
pressures were quite intense. While certain individual firms are

-7-

under strain and are having to aim for scaled-down balance
sheets, they appear to be the exception.

Michael J . P r e l l December 1 7 , 1 9 9 1

F M BRIEFING O C

-- DOMESTIC

ECONOMIC OUTLOOK

S h o r t l y a f t e r t h e l a s t FOMC m e e t i n g , incoming i n f o r m a t i o n l e d

u s t o c o n c l u d e t h a t t h e economy p r o b a b l y was t u r n i n g down a g a i n .

In

essence, i t l o o k e d l i k e t h e downside r i s k s t o which w e had been
p o i n t i n g were i n f a c t m a t e r i a l i z i n g . Unfortunately, subsequent d a t a

h a v e , on t h e whole, s u p p o r t e d t h a t i n i t i a l a s s e s s m e n t . C e n t r a l t o t h e c h a n g e i n t h e n e a r - t e r m o u t l o o k was t h e n e g a t i v e news r e c e i v e d i n mid-November inventories.

on r e t a i l s a l e s and

The i n i t i a l r e a d i n g s on s a l e s t h r o u g h O c t o b e r s u g g e s t e d

the d i s t i n c t p o s s i b i l i t y o f a d e c l i n e t h i s q u a r t e r i n o v e r a l l r e a l

consumer o u t l a y s .

And d a t a on r e t a i l i n v e n t o r i e s t h r o u g h September Although i t a p p e a r e d

i n d i c a t e d a b u i l d - u p t h a t w e had n o t f o r e s e e n .

t h a t a s i g n i f i c a n t p o r t i o n of t h i s a c c u m u l a t i o n was a c c o u n t e d f o r by

i m p o r t s , w e f e l t t h a t a good p a r t of t h e e n s u i n g a d j u s t m e n t i n s t o c k s would come a t t h e e x p e n s e o f d o m e s t i c p r o d u c e r s .
A f t e r t h e Greenbook w a s p u b l i s h e d l a s t week, w e r e c e i v e d

a n o t h e r month's w o r t h of r e t a i l t r a d e d a t a , and t h e y s u g g e s t t h a t t h i n g s may be g o i n g a b i t more p o o r l y t h a t w e had a n t i c i p a t e d . Sales

f o r November were s o f t , a n d t h o s e f o r p r i o r months were r e v i s e d down c o n s i d e r a b l y , i n d i c a t i n g a s t i l l weaker f o u r t h - q u a r t e r spending p a c e . Meanwhile, i n v e n t o r i e s c o n t i n u e d t o a c c u m u l a t e on r e t a i l e r s ' i n October.
I don't

shelves

want t o make a l o t o f t h e d i f f e r e n c e s from our

e x p e c t a t i o n s i n t h e s e p r e l i m i n a r y r e p o r t s ; t h e main p o i n t i s s i m p l y t h a t t h e l a t e s t numbers h a v e r e i n f o r c e d t h e b a s i c message of our forecast: namely, t h a t weak employment and income and d i m i n i s h e d

c o n f i d e n c e have d e a l t a blow t o consumer demand and t o o v e r a l l economic a c t i v i t y .

FOMC:

12/17/91

- 2 -

Michael J. P r e l l

T h i s i s not t o s a y t h a t t h e economy has c o l l a p s e d .

On

average, a g g r e g a t e p r o d u c t i o n worker hours i n October and November matched t h e t h i r d - q u a r t e r l e v e l , a s t h e workweek of t h o s e s t i l l employed remained f i r m ; a s we n o t e d i n t h e Greenbook, i f one b e l i e v e d t h a t p r o d u c t i v i t y i s b e i n g improved, t h e n t h e r e would b e r e a s o n t o hope t h a t o u t p u t w i l l be up i n t h e c u r r e n t q u a r t e r .
Of c o u r s e , i f

t h a t o u t p u t should e n d up i n u n d e s i r e d i n v e n t o r i e s , i t would n o t bode

w e l l for early 1992.

A important p o s i t i v e f o r t h e near t e r m i s t h e n

f a c t t h a t s i n g l e - f a m i l y housing s t a r t s jumped i n October and h e l d t h a t g a i n i n November, according t o t h e f i g u r e s r e l e a s e d t h i s morning; t h i s s u g g e s t s t h a t t h e lower mortgage r a t e s may be s u s t a i n i n g t h e recovery i n r e s i d e n t i a l c o n s t r u c t i o n i n t h e f a c e of a l l t h e n e g a t i v e s i n t h e economic environment. And our most c u r r e n t i n d i c a t o r of a c t i v i t y - - t h e

w e e k l y f i g u r e s on i n i t i a l c l a i m s f o r unemployment compensation-­

e x h i b i t e d only a m i l d d e t e r i o r a t i o n through t h e end of November.

It

may be worth n o t i n g i n t h i s r e g a r d t h a t many of t h e p a y r o l l c u t s t h a t have been announced r e c e n t l y have p r e t t y l o n g f u s e s ; t h e y may be a f f e c t i n g consumer confidence--and p o l i t i c a l debate--today,
but the

a c t u a l job l o s s e s w i l l n o t occur f o r some t i m e . Weighing a l l of t h e evidence, w e c a m e up w i t h a f o r e c a s t of j u s t a s m a l l d i p i n economic a c t i v i t y i n t o t h e w i n t e r months, followed by moderate growth t h e r e a f t e r . For t h e n e a r t e r m , our p r o j e c t i o n

r e f l e c t s i m p o r t a n t l y t h e judgment t h a t t h e e x i s t i n g i n v e n t o r y
imbalance i s s m a l l and t h a t t h e n e c e s s a r y p r o d u c t i o n adjustment i s a l r e a d y under way--as l a s t month. s u g g e s t e d by t h e d e c l i n e i n manufacturing o u t p u t

W e a l s o b e l i e v e t h e immediate downside r i s k s t o f i n a l

demand a r e l i m i t e d r e l a t i v e t o o u r a l r e a d y weak p r o j e c t i o n .

If

nothing else, w e don't see much r i s k of a n o t h e r d i v e i n a u t o s a l e s and p r o d u c t i o n l i k e t h a t which p l a y e d so l a r g e a p a r t i n t h e economic c o n t r a c t i o n a y e a r ago.

FOMC:

12/17/91

- 3 -

Michael J. P r e l l

P e r h a p s t h e b i g g e r i s s u e w i t h respect t o t h e f o r e c a s t i s t h e projected upturn i n a c t i v i t y s t a r t i n g next spring. To a c o n s i d e r a b l e

degree, t h a t u p t u r n i s s i m p l y t h e r e s u l t of i n v e n t o r i e s ceasing t o
decline--a s i g n i f i c a n t p l u s f o r r e a l GDP a f t e r t h e s u b s t a n t i a l B u t , as t h e e x p e r i e n c e t h i s y e a r

liquidation i n the f i r s t quarter.

shows, any e n s u i n g r e c o v e r y i s g o i n g t o be weak a n d u n s u s t a i n a b l e u n l e s s t h e r e i s a l s o a s o l i d p i c k u p i n f i n a l demand, s u p p o r t e d by g r o w t h i n employment a n d income.
T h e r e c e n t f a l t e r i n g of t h e

e x p a n s i o n h a s f o r c e d u s t o re-examine

o u r view of t h e f o r c e s

i n f l u e n c i n g f i n a l demand, and w e h a v e r e a c h e d a few t e n t a t i v e conclusions. F i r s t , i n r e t r o s p e c t , t h o s e who h a d a r g u e d t h a t , o n c e t h e i n v e n t o r y c y c l e t h a t o c c u r r e d d u r i n g t h e Gulf c r i s i s was o v e r , w e ' d
s t i l l h a v e a v e r y s o f t economy, h e l d down by l o n g e r - t e r m p r o b l e m s , h a d
it r i g h t .
I m i g h t q u i b b l e w i t h t h e i r r e a s o n i n g i n some i n s t a n c e s , b u t

t h e f a c t o r s t h a t w e h a d t h o u g h t a l l a l o n g would r e s u l t i n a s l u g g i s h

r e c o v e r y c l e a r l y h a v e p r o v e n more p o w e r f u l a n d more p e r s i s t e n t t h a n w e anticipated. Among o t h e r t h i n g s , w e may n o t h a v e appreciated t h e

dynamics of t h e i n t e r a c t i o n among t h e s t o c k a d j u s t m e n t processes t h a t

a r e t a k i n g place.

W e knew, f o r e x a m p l e , t h a t t h e f i n a n c i a l s e c t o r had

t o o many b u i l d i n g s a n d t o o many p e o p l e i n them, b u t w e d i d n ' t anticipate--at l e a s t n o t fully--how t h e commercial r e a l e s t a t e b u s t

would i n t e n s i f y t h e p r e s s u r e s on t h a t s e c t o r and v i c e v e r s a . I n g e n e r a l , w e p r o b a b l y d i d n o t make a d e q u a t e a l l o w a n c e f o r
t h e demand-reducing

e f f e c t s of t h e s t r u c t u r a l a d j u s t m e n t s o c c u r r i n g i n

s u c h i n d u s t r i e s a s c o m p u t e r s , a i r l i n e s , a n d r e t a i l and w h o l e s a l e
t r a d e , where f i r m s - - i n

some cases u n d e r t h e stress imposed by
f i n a l l y c o n f r o n t i n g t h e t e c h n o l o g i c a l and Slashing

excessive leverage--are

c o m p e t i t i v e pressures t h a t h a v e b e e n m o u n t i n g f o r y e a r s .

p a y r o l l s i s t h e o r d e r of t h e d a y , a n d i n t h e p r o c e s s , labor income i s

FOMC:

12/17/91

- 4 -

Michael J . P r e l l

being destroyed.

And, though b l u e - c o l l a r and l o w - s k i l l w o r k e r s have

e x p e r i e n c e d t h e g r e a t e s t i n c r e a s e s i n unemployment, t h e media seem t o have g i v e n d i s p r o p o r t i o n a t e a t t e n t i o n t o t h e w h i t e - c o l l a r and p r o f e s s i o n a l l a y o f f s - - t h e r e b y h e l p i n g t o b r o a d e n t h e s e n s e of i n s e c u r i t y among t h e p o p u l a c e . The f a c t t h a t many h o u s e h o l d s see

t h e m s e l v e s as f i n a n c i a l l y o v e r e x t e n d e d o n l y a d d s t o t h e c o n t r a c t i o n a r y consequences. F i n a l l y , as best w e c a n j u d g e , changes i n f i n a n c i a l m a r k e t s and t h e g r o s s l y o u t s i z e d s t o c k s of p h y s i c a l c a p i t a l i n some s e c t o r s p r o b a b l y h a v e d u l l e d t h e e f f e c t s of i n t e r e s t r a t e r e d u c t i o n s t o a g r e a t e r degree t h a n w e a n t i c i p a t e d . Monetary p o l i c y i s n ' t p u s h i n g on

a s t r i n g , b u t it i s h a v i n g t o work h a r d e r t o get a g i v e n s p e n d i n g

response.
T h e u p s h o t of t h i s a n a l y s i s i s t h a t w e t h i n k t h a t a g g r e g a t e

demand i s g o i n g t o t e n d t o be w e a k e r , f o r l o n g e r t h a n w e p r e v i o u s l y
had been e x p e c t i n g .
T h i s i s r e f l e c t e d i n t h e f a c t t h a t r e a l GDP

is

a p p r e c i a b l y l o w e r a l l t h e way t h r o u g h 1 9 9 3 i n t h e c u r r e n t Greenbook
forecast t h a n i n o u r l a s t p r o j e c t i o n - - e v e n
t h e d o l l a r exchange r a t e a r e a s h a d e lower.

t h o u g h i n t e r e s t r a t e s and Output d o e s n o t r e g a i n relatively

i t s 1 9 9 0 peak l e v e l u n t i l t h e t h i r d q u a r t e r o f n e x t year--a
l o n g p e r i o d of depressed o u t p u t - - a n d
mild.

the expansion t h a t follows i s

T h e f a c t t h a t our f o r e c a s t c o n t a i n s s u c h a t e p i d economic

p e r f o r m a n c e o v e r a l l might s u g g e s t t h a t w e a r e n o t b e i n g w i l d l y o p t i m i s t i c a b o u t t h e o u t l o o k ; b u t it of c o u r s e d o e s n o t g u a r a n t e e t h a t growth w i l l resume, as s c h e d u l e d , i n t h e s e c o n d q u a r t e r of n e x t y e a r . The Greenbook b a s i c a l l y p r o j e c t s t h a t t h e d e c l i n e s i n i n t e r e s t r a t e s
t h a t have o c c u r r e d t h u s f a r , p l u s t h e a n t i c i p a t e d f u r t h e r d e c l i n e i n

l o n g - t e r m y i e l d s , w i l l b o l s t e r h o u s i n g demand a n d t h a t consumer s p e n d i n g i n g e n e r a l w i l l p i c k up by n e x t s p r i n g as t h e j o b l o s s e s

FOMC: 12/17/91

- 5 -

Michael J. P r e l l

a s s o c i a t e d w i t h t h e n e a r - t e r m i n v e n t o r y c o r r e c t i o n abate.

It's

a l m o s t a case of d e j a vu a l l o v e r a g a i n , w i t h a r e p e t i t i o n of t h e 1991 upswing--but
w e e x p e c t t h e u p t u r n w i l l be s u s t a i n e d t h i s t i m e ,

given

t h a t t h e r e a l a d j u s t m e n t s w i l l h a v e p r o g r e s s e d f u r t h e r i n a number of t r o u b l e d s e c t o r s , t h a t some p e n t - u p demand f o r cars a n d o t h e r consumer g o o d s w i l l h a v e d e v e l o p e d , a n d t h a t many b u s i n e s s e s and h o u s e h o l d s
w i l l h a v e r e d u c e d t h e i r debt b u r d e n s f u r t h e r .

O b v i o u s l y , w e would n o t want t o p u t t o o f i n e a p o i n t on t h e t i m i n g a n d i n i t i a l s t r e n g t h o f t h e u p t u r n , g i v e n t h e many uncertainties i n our analysis. I f n o t h i n g e l s e , w e h a v e no way of

p r e d i c t i n g what t h e f i s c a l a u t h o r i t i e s w i l l do, a n d e v e n t s a b r o a d , which T e d w i l l d i s c u s s i n a moment, a l s o p r e s e n t some r i s k s . I n our

view, however, i t i s r e a s o n a b l e t o a n t i c i p a t e m o d e r a t e g r o w t h o v e r t h e n e x t t w o y e a r s , w i t h o u t any a d d i t i o n a l e a s i n g of money m a r k e t conditions.
I would c h a r a c t e r i z e t h e r i s k s of t h i s p r o j e c t i o n as

b e i n g b e t t e r balanced--more

symmetric--than

has been t r u e f o r a wh ile.

Even i f you share t h a t view, it o b v i o u s l y d o e s n o t p r e c l u d e c o n s i d e r a t i o n o f t h e p o t e n t i a l r i s k s a n d rewards o f a l t e r n a t i v e courses of a c t i o n . One f a c t o r t h a t I p r e s u m e m i g h t i n f l u e n c e y o u r

t h i n k i n g on t h a t s c o r e i s t h e o u t l o o k f o r i n f l a t i o n .

Our judgment i s

t h a t a d i s i n f l a t i o n a r y p r o c e s s i s w e l l i n t r a i n , and t h a t f u r t h e r p r o g r e s s would b e made t o w a r d p r i c e s t a b i l i t y e v e n if t h e economy were t o be, f o r a w h i l e , s i g n i f i c a n t l y s t r o n g e r t h a n we've p r o j e c t e d . L o o k i n g a t t h e c o r e CPI a s a rough m e a s u r e of t h e u n d e r l y i n g p r i c e t r e n d , w e h a v e s e e n t h e 12-month i n c r e a s e l i n g e r i n g a t 4-1/2 p e r c e n t recently. But t h a t number i s s t i l l r e f l e c t i n g t h e e a r l i e r e f f e c t s o f a n d w e e x p e c t t o see And,

t a x i n c r e a s e s and e n e r g y p r i c e p a s s - t h r o u g h s , c o n s i d e r a b l y lower year-on-year

c h a n g e s w i t h i n a few m o n t h s .

g i v e n t h e s l a c k i n l a b o r m a r k e t s and i n p r o d u c t i v e c a p a c i t y more g e n e r a l l y , w e e x p e c t d i s i n f l a t i o n t o c o n t i n u e e v e n as t h e economy

FOMC: 12/17/91

- 6 -

Michael J. Prell

picks up, with the rate of consumer price increase dropping to 3 percent in 1993. Something at least close to that rate probably would be attainable even if the economy were to grow 3 percent over the coming year, instead of the 2 percent we've predicted--but unless activity began to decelerate thereafter, possibly encouraged by a tightening of policy, the prospects of extending the disinflation trend beyond 1993 likely would be dimmed.

*************

Edwin M. Truman
December 17, 1991
FOMC Presentation - International Develovments

Turning to the external sector of the U.S. economy, the surprisingly sharp decline in net exports during the third quarter reflected an unusually rapid expansion of imports more than a retrenchment of exports; exports were still expanding at an annual rate of more than five percent. As Mike just indicated, we suspect that a good deal of the bulge in imports - - much of which was in consumer goods, autos, and oil

- - went into domestic inventories. The likely rebalancing
Such

of these inventories could knock as much as $5 to $6 billion, at an annual rate, off the level of imports during the next two quarters. an adjustment, along with the weaker near-term outlook for domestic demand that Mike has just outlined, has led us to project a decline in real imports before the winter is over. Thereafter, we expect imports to

expand significantly as domestic demand recovers.
We have had less cause to alter the projected path of exports. Reports on export orders point to continued expansion in the export sector, at least through the fourth quarter. Our relative optimism about expdrts been tempered to some extent by recent signs of continued

sluggishness in economic activity in major foreign industrial countries, and we have marked down - - by about 1/2 percent - - the level of overall foreign economic activity by the fourth quarter of next year. While the weakening of our outlook for foreign growth has tended to damp our projection for U . S . exports, developments in foreign exchange markets have worked in the opposite direction to brighten export prospects. Our models tell us that the dollar’s lower level compared

- 2 -

with the November Greenbook roughly offsets the effects on exports of the
weaker outlook for growth abroad.
In sum, with the growth of imports revised down significantly in
the near term, and with the outlook for exports revised down only
slightly, we expect net exports to make a significant positive
contribution to GDP during the fourth quarter and the first quarter.
Moreover, we are projecting small additional positive contributions
through the rest of 1992.
Three principal risks to our outlook for the external sector are
the dollar, oil prices, and foreign economic activity.
Although the dollar has fallen recently, the decline has not reversed all of the increase over the first half of the year

--

an

increase that seemed to reflect post-Gulf War euphoria. The dollar is above its level at the end of 1990; however, we estimate that the differential in long-term real interest rates, which we think is a major influence on the dollar, has moved against the dollar on balance over the course of the year. This raises the possibility that the dollar could fall further, contrary to our current projection, particularly in the near term as news of weakness in the U.S. economy continues to pour in. This risk to our outlook for real net exports, therefore, is positive in terms of economic activity. A further depreciation of the dollar below the path we have projected would add to the growth of net exports over the year ahead. For example, a five percent decline in the average foreign exchange value of the dollar in the first quarter that extended through the forecast period would add somewhat more than 1/4 percent to real GDP by the fourth quarter of next year.

- 3 -

Developments in world oil markets could pose another possible positive risk to the outlook. We have assumed that spot oil prices will remain about unchanged from their recent levels as Kuwait and Iraq production come back on stream gradually over the next two years. However, significant downward pressure on oil prices could emerge (in the near term at least) if production in Kuwait and Iraq recovered more rapidly while Saudi Arabia continued producing at or near capacity. Downward pressure on oil prices also could emerge because of sluggish growth in global demand - - acting as a kind of automatic stabilizer.
A

third risk to the outlook, and one that & negative, concerns

the outlook for foreign economic activity. The extent of slowing in real growth abroad during 1991 has surprised us

- - our

current estimate of

real growth on average in the foreign industrial countries is about 1 percent less than we projected at the time of the February FOMC meeting. The largest revisions have been for growth in western Germany and in the United Kingdom.
Our current outlook is for slow growth in the foreign industrial

countries during this quarter and next

- - 1-1/2 percent on average at an

annual rate. Growth is expected to pick up by the second half of 1992 to
2 - 3 / 4 percent.

This outlook contains considerable uncertainty, and many of the risks to the forecast appear to be negative. The rebound in activity forecast for 1992 in several of the major foreign countries - - Japan, the United Kingdom, and Canada in particular - - depends importantly on the effects of monetary easing that is already in place. Should these

effects come more slowly or be offset by other factors, a significantly weaker foreign outcome could result.

- 4 -

For Japan, the weakened condition of financial institutions and the potential for renewed declines in stock and land prices are downside risks. Investment spending, which had been very strong, could be further

diminished by lack of available credit. A decline in household spending could occur should further drops in asset prices or a rise in unemployment cause consumer confidence to fall. We have estimated the effects on our outlook for the U.S. external sector of a "worst case" scenario in which there is little or no growth abroad in the near term and only a weak recovery in 1992, producing growth over the four quarters of next year about one percent lower than we are now projecting. Our model simulation suggests that

such a scenario would chop almost 3 / 4 of a percentage point from the level of U.S. real GDP by the fourth quarter of 1992. While I could point to some upside risks to our forecast for
growth abroad, those risks seem less likely on balance than the risks on
the downside. Moreover, my sense is that policy makers in the foreign
industrial countries, with the possible exception of Japan, are not in a
position, or do not have the inclination, to counter aggressively any
downside risks.
That completes our presentation, Mr. Chairman,

Deceliher 17, 1991
FOMC B R I E F I N G Donald L . Kohn

The weakness c u r r e n t l y e v i d e n t i n t h e economy i s a r e f l e c ­ t i o n , a t l e a s t in p a r t , of monetary p o l i c i e s f o l l o w e d i n e a r l i e r q u a r t e r s t h i s y e a r , as t h e y have i n t e r a c t e d w i t h more subdued demands f o r goods and s e r v i c e s t h a n had been e x p e c t e d .

In r e s p o n s e t o

i n d i c a t o r s t h a t demands were f a l l i n g s h o r t o f e x p e c t a t i o n s , m o n e t a r y p o l i c y h a s e a s e d a p p r e c i a b l y o v e r t h e l a s t few m o n t h s . These a c t i o n s

w i l l h a v e o n l y minor e f f e c t s i n t h e n e a r term, b u t t h e y do p r o v i d e a

reasonable b a s i s f o r expecting a strengthening i n a c t i v i t y next spring and summer.
T h e i s s u e presented a t t h i s meeting i s whether t h e

a c t i o n s t a k e n o v e r t h e l a s t f e w months h a v e been s u f f i c i e n t t o t i l t t h e odds f a r enough i n f a v o r of g e t t i n g a rebound o f t h e d i m e n s i o n s d e s i r e d by t h e Committee. The d e c l i n e i n t h e f e d e r a l f u n d s r a t e o f 1 2 5 b a s i s p o i n i s s i n c e J u l y i s s h o w i n g up i n a number o f f i n a n c i a l i n d i c a t o r s , and i n t h i s r e g a r d t h e s i t u a t i o n d i f f e r s somewhat from t h a t p r e v a i l i n g i n t h e

summer.

The d r o p a p p e a r s t o have o u t p a c e d any f a l l i n n e a r - t e r m i n ­

f l a t i o n e x p e c t a t i o n s . s o t h a t r e a l s h o r t - t e r m r a t e s a l s o have r e g i s ­ t e r e d s i g n i f i c a n t d e c l i n e s , t o t h e i r lowest l e v e l s s i n c e 1980. Nomi­

n a l l o n g - t e r m r a t e s h a v e moved down n o t i c e a b l y a s w e l l , t h o u g h t h e e x t e n t t o which t h i s h a s shown t h r o u g h t o r e a l r a t e s p e r h a p s i s more questionable. The d r o p i n i n t e r e s t r a t e s h a s a f f e c t e d t h e e x c h a n g e

m a r k e t . w h e r e t h e d o l l a r a l s o h a s f a l l e n a p p r e c i a b l y in b o t h n o m i n a l and r e a l terms s i n c e m i d y e a r . The r e d u c t i o n s i n nominal s h o r t - t e r m i n t e r e s t r a t e s a r e h a v ­ i n g t h e i r e f f e c t s on t h e m o n e t a r y a g g r e g a t e s .
M2 and M 3 h a v e resumed

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growing i n t h e f o u r t h q u a r t e r , a f t e r d e c l i n i n g i n t h e t h i r d .

Their

growth i s n o t e s p e c i a l l y r o b u s t , b u t d e c r e a s e s i n s h o r t - t e r m r a t e s have o f f s e t weaker income. so t h a t expansion of t h e a g g r e g a t e s i s i n l i n e w i t h e x p e c t a t i o n s a t t h e beginning of O c t o b e r .

M1 has a c c e l e r ­

a t e d m a r k e d l y - - t o a 12-1/2 p e r c e n t r a t e from September t o December. C r e d i t f l o w s , o u t s i d e t h e F e d e r a l government, remain very s l u g g i s h , but do n o t appear t o have slowed f u r t h e r , d e s p i t e t h e d e c e l e r a t i o n of nominal s p e n d i n g s i n c e t h e second q u a r t e r . Moreover, c r e d i t s t a n d a r d s

a t banks seem t o have s t a b i l i z e d . and t h e s e i n s t i t u t i o n s have been about matching F e d e r a l Reserve e a s i n g moves w i t h prime r a t e reduc­ t i o n s - - i n c o n t r a s t w i t h e a r l i e r t h i s year when t h e spread of t h e prime over market r a t e s widened as t h e f e d e r a l f u n d s r a t e f e l l . Perhaps because t h e e a s i n g a c t i o n s over t h e l a s t few months have been s e e n a s e v e n t u a l l y e f f e c t i v e i n s u p p o r t i n g t h e economy, t h e worsening n e a r - t e r m economic p r o s p e c t s have had a muted impact on longer-term s e c u r i t y p r i c e s . The y i e l d c u r v e remains u n u s u a l l y s t e e p ­

l y upward s l o p e d . s t i l l s u g g e s t i n g an e x p e c t e d r i s e i n s h o r t - t e r m r a t e s a t some p o i n t i n t h e f u t u r e : s t o c k p r i c e s have only edged o f f record l e v e l s and p r i c e - e a r n i n g s r a t i o s a r e e l e v a t e d : and r i s k p r e ­

m i u m s i n p r i v a t e s e c u r i t i e s markets and between p r i v a t e and T r e a s u r y
s e c u r i t i e s a r e v e r y low. However. t h e s e market c o n d i t i o n s a p p e a r t o embody e x p e c t a ­ t i o n s o f a s l i g h t f u r t h e r e a s i n g i n monetary p o l i c y over t h e n e a r -

term.

As a consequence, keeping f e d e r a l f u n d s r a t e s unchanged, a s

under a l t e r n a t i v e B . i s l i k e l y t o produce some modest upward p r e s s u r e
on o t h e r i n t e r e s t r a t e s for a t i m e , w i t h t h e subsequent movement o f

i n t e r e s t r a t e s depending on t h e i m p l i c a t i o n s o f incoming d a t a f o r t h e s t r e n g t h o f c r e d i t demands and f u t u r e p o l i c y moves. The f l a t f e d e r a l

funds r a t e of a l t e r n a t i v e B. as Mike n o t e d , i s t h e assumption behind

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t h e greenbook f o r e c a s t .

Choosing t h i s a l t e r n a t i v e would seem

a p p r o p r i a t e i f t h a t o u t l o o k were t h o u g h t t o b e a c c e p t a b l e . and t h e r i s k s f a i r l y evenly balanced. L i v i n g w i t h m o d e r a t e l y h i g h r a t e s of

unemployment f o r a t i m e , a s i n t h e g r e e n b o o k . would h e l p t o p u t i n f l a t i o n on a downward t r a j e c t o r y toward p r i c e s t a b i l i t y o v e r coming years. P r o g r e s s i n b r i n g i n g i n f l a t i o n below t h e 4 t o 5 p e r c e n t r a n g e

p r e v a i l i n g o v e r t h e 1980’s h a s b e e n l i m i t e d s o f a r , and t h e l e v e l of longer-term i n t e r e s t rates implies deeply rooted market skepticism a b o u t any l a s t i n g r e d u c t i o n i n t h e u n d e r l y i n g r a t e o f i n f l a t i o n . While a d d i t i o n a l e a s i n g a t t h i s time need n o t d e f l e c t i n f l a t i o n f r o m a g r a d u a l downward p a t h , i t would t e n d t o make s u c h a p a t h l e s s c e r t a i n , and p r o b a b l y would a t l e a s t p o s t p o n e a n y change i n m a r k e t a t t i t u d e s . A l t e r n a t i v e B would a l s o b e j u s t i f i e d by a judgment t h a t t h e r e w a s a s i g n i f i c a n t r i s k t h a t t h e greenbook i s t o o p e s s i m i s t i c on t h e o u t l o o k f o r t h e economy.
If t h e economy d o e s t u r n o u t t o b e

materially stronger than anticipated, further easing a t t h i s t i m e might w e l l r e q u i r e a prompt and s i g n i f i c a n t t i g h t e n i n g t o k e e p i n f l a ­ t i o n r a t e s t i l t e d down, g i v e n t h e small gap between t h e unemployment

r a t e and t h e n a t u r a l r a t e compared t o some p r i o r r e c e s s i o n s . and t h e
l a g s f r o m m o n e t a r y p o l i c y t o t h e economy. Reversing p o l i c y i n a time­

l y f a s h i o n may b e e s p e c i a l l y d i f f i c u l t when t h e r e h a s a l r e a d y b e e n one f a l s e s t a r t t o t h e r e c o v e r y . and when money growth is l e s s l i k e l y t o s i g n a l a n e e d f o r r e s t r a i n t owing t o s t r u c t u r a l a d j u s t m e n t s i n t h e d e p o s i t o r y s e c t o r t h a t a r e l i k e l y t o c o n t i n u e t o d e p r e s s money r e l a ­ t i v e t o income.

A l t e r n a t i v e A . o r some more modest e a s i n g of p o l i c y . would b e

a more p r e f e r a b l e c h o i c e were t h e greenbook f o r e c a s t s e e n as l i k e l y ,
b u t i n v o l v i n g a n u n a c c e p t a b l e d e g r e e of s l a c k i n r e s e r v e u t i l i z a t i o n . o r t h e Committee s a w t h e r i s k s o r c o s t s of t h e outcome f o r t h e economy

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more h e a v i l y weighted toward a s h o r t f a l l from p r o j e c t i o n s .

In effect.

t h e Committee would be judging t h a t r e a l i n t e r e s t and exchange r a t e s had n o t y e t f a l l e n t o l e v e l s t h a t gave s u f f i c i e n t a s s u r a n c e o f achiev­

i n g i t s i n t e r m e d i a t e - t e r m o b j e c t i v e s f o r t h e r e a l economy. given t h e
f o r c e s h o l d i n g back expansion.

To a c o n s i d e r a b l e e x t e n t . t h o s e f o r c e s a r e working through
t h e f i n a n c i a l system, and lower i n t e r e s t r a t e s w i l l h e l p t o a l l e v i a t e t h e m - - f o r example, by reducing d e b t s e r v i c e burdens of borrowers and making them more c r e d i t w o r t h y , a n d by b o l s t e r i n g t h e p r o f i t s of some i n t e r m e d i a r i e s , l i k e many b a n k s whose l i a b i l i t i e s r e p r i c e more o f t e n t h a n t h e i r a s s e t s , enhancing t h e i r a b i l i t y t o r a i s e c a p i t a l . I n any

c a s e . lower market i n t e r e s t r a t e s w i l l encourage borrowing and s p e n d ­ i n g by t h o s e w i t h a c c e s s t o s e c u r i t i e s m a r k e t s . buoy a s s e t v a l u e s by r e d u c i n g c a p i t a l i z a t i o n r a t e s . and s t i m u l a t e n e t e x p o r t s t h r o u g h a d e c l i n e i n d o l l a r exchange rates. Easing a c t i o n i n t h e United S t a t e s

and downward p r e s s u r e s on t h e d o l l a r might g i v e scope f o r a f e w coun­ t r i e s t o f o l l o w s u i t , damping t h e drop i n t h e d o l l a r b u t b o l s t e r i n g a c t i v i t y more b r o a d l y . P r o s p e c t i v e p a t h s f o r broad money growth could be s e e n a s weighing on t h e s i d e of a f u r t h e r r e d u c t i o n i n s h o r t - t e r m i n t e r e s t rates. I n t h e bluebook. t h e November-to-March growth of M2 under

a l t e r n a t i v e B remains a t 3 p e r c e n t . w e l l e n t r e n c h e d i n t h e lower h a l f

o f t h e t e n t a t i v e range f o r n e x t y e a r , a n d shows l i t t l e s i g n of a c ­
celerating. funds r a t e cent. I n f a c t . our e s t i m a t e of M 2 growth c o n s i s t e n t w i t h a f l a t and greenbook income f o r a l l of 1 9 9 2 i s o n l y 3 - 1 / 2 p e r -

The r e l a t i o n o f money t o income h a s been f r a u g h t w i t h u n c e r ­

t a i n t i e s i n r e c e n t y e a r s , but unexpected s h o r t f a l l s i n money have
preceded u n a n t i c i p a t e d weakness i n income, If t h e Committee wished t o

a s s u r e i t s e l f of s t r o n g e r nominal income. i t may want t o f o s t e r a more

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s u b s t a n t i a l p i c k u p i n M2 f r o m 1 9 9 1 t o 1 9 9 2 .

Under t h e l o w e r r a t e s of

a l t e r n a t i v e A. MZ g r o w t h t h r o u g h March would a v e r a g e 3 - 3 1 4 p e r c e n t , and t h i s a g g r e g a t e would b e growing a t a r o u n d a 4 - 1 1 2 p e r c e n t r a t e by March, With t h e e x t r a push f r o m h i g h e r income a s s o c i a t e d w i t h l o w e r

i n t e r e s t r a t e s k i c k i n g i n l a t e r i n t h e y e a r , w e would p r o j e c t M Z growth f o r 1992 a t a r o u n d t h e 4 - 1 / 2 p e r c e n t m i d d l e o f i t s t e n t a t i v e r a n g e u n d e r a l t e r n a t i v e A. Given some f u r t h e r upward move i n v e l o c ­

i t y , a s c r e d i t f l o w s c o n t i n u e t o b y - p a s s i n t e r m e d i a r i e s and d e p o s i t o r s r e a c h f o r y i e l d , 4 - 1 / 2 p e r c e n t M2 growth for 1992 m i g h t b e c o n s i s t e n t w i t h 5 - 1 / 2 p e r c e n t e x p a n s i o n o f n o m i n a l GDP. somewhat a b o v e t h e 5 p e r c e n t n o m i n a l GDP growth i n t h e greenbook f o r e c a s t .
To b e sure, a f u r t h e r ease a t t h i s t i m e would r a i s e t h e odds of an e v e n t u a l need f o r p o l i c y t o r a i s e s h o r t - t e r m i n t e r e s t r a t e s .

If t h e u n d e r l y i n g demands f o r goods and s e r v i c e s a r e n o t s i g n i f i c a n t l y s t r o n g e r t h a n embodied i n t h e greenbook f o r e c a s t , s u c h a r e v e r s a l p r o b a b l y would n o t b e needed f o r some t i m e .

A major f i s c a l stimulus

e a r l y n e x t y e a r c o u l d b e a f a c t o r t h a t would t e n d t o b o o s t demand more than anticipated. However, t h e outcome of t h e p o l i t i c a l p r o c e s s now

c o n s i d e r i n g f i s c a l a c t i o n i s i m p o s s i b l e t o p r e d i c t , a n d how it might b e a f f e c t e d by t h e c o u r s e of m o n e t a r y p o l i c y i m p o n d e r a b l e . In these

c i r c u m s t a n c e s , t h e greenbook a s s u m p t i o n of no c h a n g e i n f i s c a l p o l i c y may b e t h e o n l y p r a c t i c a l and r e s p o n s i b l e p r e s u m p t i o n for m o n e t a r y policy. Even w i t h an e x p a n s i v e f i s c a l p o l i c y , s o l o n g a s t h e Commit-

t e e s t o o d w i l l i n g t o r a i s e i n t e r e s t r a t e s when n e e d e d , a l t e r n a t i v e A
o r some e a s i n g of p o l i c y need n o t d e r a i l t h e t r e n d t o w a r d l o w e r i n f l a ­ tion.
I t i s t h i s d i s i n f l a t i o n t r e n d , r a t h e r t h a n any s h o r t - t e r m v a r i ­

a t i o n i n i n t e r e s t rates, t h a t i s key t o encouraging sound, l a s t i n g balance sheet r e s t r u c t u r i n g .